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Islamic Finance Law Economics and Practice pdf

  • Book Title:
 Islamic Finance Law Economics And Practice
  • Book Author:
Mahmoud A. El-Gamal
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  • Introduction 1
  • Finance without Interest? 2
  • Distinguishing Features of Islamic Finance 7
  • Prohibition-Driven Finance 8
  • Jurists, Shari‘a Boards, and Innovation 11
  • Lawyers and Regulatory Arbitrage 13
  • Islamic Transactions Law as Common Law 15
  • Precedents, Analogies, and Nominate Contracts 17
  • Tradeoff between Efficiency and Legitimacy 20
  • Limits and Dangers of Shari‘a Arbitrage 21
  • Risk of Mispricing 22
  • Legal and Regulatory Risks 23
  • Jurisprudence and Arbitrage 26
    • Islamic Law and Jurisprudence 27
  • The Canon: Qur’an, Tradition, and Consensus 27
  • Juristic Inference (Ijtihad ) and Benefit Analysis 28
  • From Classical to Contemporary Jurisprudence 30
  • Jurisprudence, Revival, and Codification 31
  • Institution of Fatwa and Islamic Finance 32
  • Arbitraging Classical Jurisprudence 35
  • Shari‘a-Arbitraging Classical Property Law 36
  • Arbitraging Classical Contract Conditions 42
  • Arbitrage, Ruses, and Islamic Finance 44
  • vii
  • viii Contents
  • Two Major Prohibitions: Riba and Gharar 46
    • The Prohibition of Riba 49
  • Canonical Texts on Riba 49
  • Economic Substance of the Prohibition of Riba 52
  • The Prohibition of Gharar 58
  • Definition of Gharar 59
  • Economic Substance of Prohibition 60
  • Insurance and Derivatives 61
  • Bundled vs. Unbundled Credit and Risk 62
  • Sale-Based Islamic Finance 64
    • Basic Rules for Sales 65
  • Trust Sales: Murabaha, Tawliya, Wad. i‘a                                      67
  • Currency Exchange (Sarf ) 68
  • Same-Item Sale-Repurchase (‘Ina) 70
  • Same-Item Trading in ‘Ina and Tawarruq 70
  • Custody Sale (Bay‘ Al-‘uhda) and Sukuk Al-ijara 73
  • Cost of Funds: Interest-Rate Benchmarks 74
  • Opportunity Cost for Conventional Fund Providers 75
  • Viability of Islamic Benchmark Alternatives 77
  • Derivative-Like Sales: Salam, Istisna‘, and ‘Urbun 81
    • Prepaid Forward Sale (Salam) 81
  • Parallel Salam 83
  • Conventional and Synthesized Forwards 86
  • Commission to Manufacture (Istisna‘ ) 90
  • Down-Payment Sale (‘Urbun) 91
  • ‘Urbun as Call Option 92
  • Leasing, Securitization, and Sukuk 97
    • General Lease Conditions 97
  • Flexible-Rate Financing 100
  • Subleasing, Repairs, and Insurance Costs 100
  • Asset-Backed Securities 102
  • Leasing and Securitization 102
  • Receivable Securitization and Sale of Debt 104
  • Bundling Asset-Based and Debt-Based Securities: A Paradox 106
  • Asset-Backed Leasing Bonds (Sukuk) 107
  • Credit-Rating Issues 108
  • Reward Pledges and Gifts Revisited 110
  • Usufruct Sukuk 113
  • Sukuk Al-Salam 114
  • Contents ix
  • Partnerships and Equity Investment 117
    • Classical Types of Partnership 117
  • Silent Partnership: Theoretical Workhorse of Islamic Finance 120
  • Valid and Defective Silent Partnerships 122
  • Common-Stock Ownership 123
  • “Islamic Screens” and Their Shortcomings 125
  • Cleansing Returns 133
  • Positive Screens and the Islamic Brand Name 134
  • Islamic Financial Institutions 135
    • Banking and Islamic Banking 137
  • Theoretical Structure: Two-Tier Silent Partnership 138
  • Deposits vs. Loans: Trust and Guaranty 144
  • Insurance and Takaful 147
  • Two Sides of the Two Debates 151
  • Shari‘a Arbitrage vs. Islamic Prudential Regulation 152
  • Generic Agency Characterization of Financial Institutions 153
  • Governance and Regulatory Solutions in Mutuality 162
    • Rent-Seeking Shari‘a Arbitrage and Absence of Mutuality 163
  • Potential for Mutuality in Islamic Banking 166
  • Need for Mutuality in Takaful 170
  • A Call for Mutuality in Banking and Insurance 171
  • Mutuality in Banking 172
  • Mutuality in Insurance 173
  • 1 0 Beyond Shari‘a Arbitrage 175
  • Shari‘a Arbitrage and Criminal Finance 176
  • Shari‘a Arbitrage at the Limit 177
  • Benchmarking ad Absurdum 178
  • Hedge-Fund Instruments – Shari‘a-Arbitrage Style 180
  • Self-Destructiveness of Shari‘a Arbitrage 181
  • Declining Shari‘a-Arbitrage Profit Margins 182
  • Dilution of the “Islamic” Brand Name 183
  • Toward a New Islamic Finance Identity 184
  • Macroeconomic Substance: Privatization Sukuk 185
  • Mosque-Based Network of Financial Mutuals 186
  • Positive Screens, Ethical Investment 188
  • Conclusion 190
  • Notes 193
  • Bibliography 213
  • Index 219


In his Address to the Nobility of the German Nation in 1520, Martin Luther wrote:

A cobbler, a smith, a peasant, every man, has the office and function of his calling, and yet all alike are consecrated priests and bishops, and every man should by his office or function be useful and beneficial to the rest, so that various kinds of work may all be united for the furtherance of body and soul, just as the members of the body all serve one another.1

A cobbler was said to have asked Luther how he could serve God within his trade of shoe making. Luther’s answer was not that the cobbler should sell a “Christian shoe,” but rather that he should make a good shoe and sell it at a fair price.2 Most interesting in Luther’s quote is the similarity of his message to Sunni Islamic tra- ditions, wherein – at least in theory – there are no distinct categories of clergy and laity, and wherein all righteous acts – including fair dealings in the marketplace – are considered important parts of religious life.3

The term “Islamic finance” brings to mind an analogy to the concept of a “Christian shoe,” rather than to good products that are fairly priced. Indeed, we shall see that the primary emphasis in Islamic finance is not on efficiency and fair pricing. Rather, the emphasis is on contract mechanics and certification of Islamicity by “Shari a Supervisory Boards.” To the extent that “Islamic” financial products also cost more than the conventional products that they seek to replace

– partly because of relative inefficiency, and partly to cover otherwise unnecessary

jurist and lawyer fees – one may make partial analogies between those certifica- tions and the European pre-Reformation practice of selling indulgence certificates. Thus, quoting Luther at the outset seems doubly appropriate, since he was simul- taneously driven to oppose religious peddling through the sale of indulgences as well as usurious practices camouflaged by the mechanics of legitimate business and finance.4

In fact, the expression “Islamic finance” suggests two competing forces at work. The noun “finance” suggests that Islamic financial markets and institutions deal with the allocation of financial credit and risk. Thus, Islamic finance must be essentially similar to other forms of finance. On the other hand, the adjective “Islamic” suggests some fundamental differences between Islamic finance and its conventional counterpart. Observers of the theory and practice of Islamic finance sense this tension between attempts to be essentially similar to conventional fi- nance (emphasizing competitiveness and efficiency) and attempts to preserve a distinctive Islamic character (emphasizing Arabic contract names and certification by religious scholars). We shall see in future chapters that this “Islamic” distinc- tion often can be preserved only at a cost, and minimization of that cost – driven by competitive pressures – may render it a distinction of form without substance.

Finance without Interest?

Most readers encounter Islamic finance first through grossly simplistic statements such as “Islam (or the Qur an) forbids interest.” This has given rise to countless jokes about “how one can get an Islamic interest-free mortgage loan.” Even rela- tively sophisticated journalists follow this process of false reductionism, followed by tongue-in-cheek qualifications. For instance, in a recent article in Fortune mag- azine, Useem (2002) reported on typical Islamic financing through credit sales, known by the Arabic name murabaha, the details of which we shall examine in some detail in Chapter 4. Reflecting on the transaction, he exclaimed:

The result looked a lot like interest, and some argue that murabaha is simply a thinly veiled version of it; the markup [bank’s name] charges is very close to the prevailing interest rate. But bank officials argue that God is in the details.

This tongue-in-cheek quotation of the statement that “God is in the details” may otherwise be viewed as offensive and condescending. However, it is surpris- ingly tolerated, and sometimes nurtured, within Islamic finance circles. It reflects the prevailing form-above-substance approach of that industry. Islamic financial forms are derived, albeit loosely, from classical sources of Islamic jurisprudence, which process of derivation gives the industry its “Islamic” label.

In fact, there are numerous instances wherein reporters begin by stating that the distinguishing feature of Islamic finance is the prohibition of interest and then proceed to report the interest rate that Islamic instruments pay. For in- stance, Reuters’ August 13, 2002, coverage of Bahrain’s $800 million sukuk (the Arabic term for “Islamic bonds”) followed their characterization of Islamic finan- cial products as “interest-free” with a report that those sukuk will pay “4 percent annual profit.” Customary explanations that the transaction is asset-based, or that what appears similar to interest is in fact profit in a sale or rent in a lease, can often leave the uninitiated reader more perplexed about the “interest-free” charac-

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